Q&A with CMMB Securities

Q. Your responses to readers seem to give the impression that investing money is the answer to almost everything. But what about the risks involved?

Nicole, Trincity

A: You are quite correct. One cannot speak about the return on an investment without considering the risks involved. Risk and return are two sides of the same coin. In fact, the higher the potential return on an investment the higher the risk involved. Last week we explored the possibility of putting money in the stock market rather than opening a new business. Of course, the stock market has a higher degree of risk than a fixed deposit or a money market account. However, despite the many downturns in the market during the course of history, stocks have ALWAYS recovered. The market recovered after the Great Depression, the Asian Crisis, and 9-11. While the recovery took some time it eventually happened. The key is to have the time to wait for the market to experience an upturn. Therefore, you would not want to put money into the market that you would need at short notice. If you have to liquidate a portfolio due to an emergency it may be when the market has fallen causing a loss on your investment.

Over the long term the probability of a high return increases significantly. In fact financial theorists have coined a new term referred to as “Time Diversification of Risk” which means in essence, that the risk of investing in the stock market decreases as the holding period of the investment increases, all things remaining constant. So examine your portfolio and decide, based on your budget, what part of your savings you can lock up in the stock market for a few years. Then, talk to a few stockbrokers to get the best advice about building a portfolio of shares.

Q. What’s the best way to educate myself about the stock market? I don’t want to become a broker, just want to make sure that I don’t get the wool pulled over my eyes.

Thomas, Gasparillo

A: The stock market is a simple thing to understand. The price of a share is determined by supply and demand. The higher the profitability and dividend payout of a share the greater is the demand for that share. Companies on the local stock exchange must publish results every quarter in the newspapers. It would be a good idea to talk to your broker and get the dates at which each company publishes results. You can then monitor what is happening to the financials of the companies listed on the exchange. If the company’s results increase from one quarter to another the price of the share most probably would increase as large pension funds begin to buy the share to benefit from the prospective dividend payout. The larger the percentage rise in a company’s profitability the greater would be the percentage rise in its share price, all things remaining constant. The extent to which the price of a share increases depends on the historical Price Earnings ratio (P/E ratio) at which the stock trades. We explained the workings of P/E ratios in a previous column.

The higher the P/E ratio, the greater is the percentage price increase for every percentage rise in the profits of the company. You can get the information about the P/Es of the various companies on the exchange from the research departments of stock brokerage firms. Try and get these from two or more brokers to get a consensus as to what the P/E of that share is because it does tend to fluctuate over time. To get an idea of where the price of a share may increase to, simply multiply the Earnings per share, which is on the face of the financial statement, by the P/E ratio. The product of these two would give an indication of where the price of a share would go based on its most recent financial performance.

Q. What is an index fund?

Satish, Diamond Vale

A: In order to understand what is an index fund you must first understand what is an index. A stock index is a capitalisation weighted price average of the shares according to certain criteria. For example in the United States, the Dow Jones Industrial Average is a weighted average value of 30 shares concentrated in the industrial sector. Similarly the Nasdaq is a weighted average value of shares in the technology sector. An index fund is a mutual fund whose aim is to outperform or do better than a particular index. The index is a benchmark against which the performance of the particular fund is measured. Investors can expect that the return on the mutual fund is at least as good as the particular index.

Therefore, if the return on the S&P 500 is 10% per year then the performance of an index fund based on the S&P 500 should be at least 10% after fees. If the return is less than that, an investor should not be investing money in the index fund and paying a portfolio manager fees for his expertise as the alternative is simply to buy a pure index that would pay the same return without having to pay fees. An index fund is suitable to investors who want a diversified investment portfolio, but would also like to benefit from the experience and expertise of portfolio managers who may be able to squeeze a few extra points out of the investment.

Questions can be sent to CMMB Securities 1830, Wrighston Road, Port-of-Spain
E-mail : cmmbsecurities@mycmmb.com